Losing $ 2B Without Anyone Knowing About It Is Much Harder Than You Think

I’ve written already (both in the SocGen Jerome Kerviel case, and now in the UBS Kweku Adoboli case) that I, as someone with extensive trading experience in varying roles on both sides of the Street, cannot comprehend how a trader can lose billions of dollars without anyone else knowing about it.

Again, I’m not trying to absolve any “rogue traders” of their guilt, but I do think that it’s indicative of much bigger problems than a bad apple trader.

Consider: 1) you need a TREMENDOUS amount of capital at risk to lose $ 2B. 2) Trades settle with real money (or, rather, its digital equivalent) – the bank transfers this money to the counterparty. On exchange traded futures, the bank is asked for margin on a nightly basis. On OTC (over the counter) trades booked vs. clients, margin is also exchanged 3) This UBS trader was on the Delta One desk, which is what we normally think of as ETFs, although swaps often feed into this desk too. For example, if a client wants long exposure to, say, the S&P 500 index, the bank might write them a swap, and the bank would hedge by buying SPY. Now, it immediately becomes clear that a trader with back office experience might have ideas about how to “fool” the risk management systems by booking out a fake client swap against massive positional punts that he is taking. In other words, TraderX goes out and buys $ 1B in SPY, and enters a fake trade into the system that says CustomerX has entered into a swap for long exposure to the S&P 500 index. Thus, according to the risk management system, TraderX is hedged: he’s long SPY in the market, but he’s short SPY exposure to Customer X – the fake trade which doesn’t exist.

It’s not that simple, though. First of all, again, to lose $ 2B, you have to have a MONSTROUS position. You can either buy tens of billions of dollars of cash instruments (assuming a loss in the neighborhood of 10%), like ETFs, or you can lever up with futures. But again, if you’re trading futures, you get asked for margin collateral on a daily basis – it makes no sense to me. So I can see how a trader could fool a risk management system (although, still, not quite to the extent you’d need to rack up a $ 2B loss), but that’s just one part of the chain! There’s still the funding of the position that is way beyond the trader’s control, and the collection of margin from the customer. (Sorry, I guess I’m not a very good rogue trader)

If you’re trading listed cash products like SPY, in our example above, your position would have to be enormous – even if a trader got long at the summer highs, and puked at the August lows, he’s still not losing more than 15%. $ 2B / 15% = $ 13B in exposure – you can’t put on that kind of a position without people at the bank knowing. Full stop. It has to be paid for. Money gets transferred. Even when we (my former trading desk) were taking billion dollar positions, which was well within the capability of my bank to handle, and well within the risk my desk routinely managed, we’d call the internal Treasury desk and just give them a heads up – these guys need to go out every night and “fund” the positions. If we just decided to buy a few billion dollars worth of, well, ANYTHING, even if it was hedged (ie, long S&P 500 stock vs short S&P 500 futures), people all the way up the chain of command would still know about it. I could put on a billion dollars in index arbitrage (again, long S&P stock vs short S&P futures), but if I grew this position size to $ 5B, or $ 10B, there would be 5 different groups in the bank looking at it. It wouldn’t be a matter of just saying “don’t worry, I have no risk, CustomerX is on the other side with a swap.”

Let’s get back to the example above: assume that TraderX, gone rogue, books a fake swap that says CustomerX has bought long swap exposure on the SPY. TraderX has taken a big SPY position in the marketplace. As the SPY position moves against the not-yet-discovered-rogue-trader, people all over the bank will be looking for collateral from CustomerX, who should owe TraderX an amount equal to what he’s lost on his SPY position.

I just talked to a former colleague of mine, who mentioned that he heard a rumor that this trade originated from a customer swap which was booked incorrectly in the system, and also hedged backwards. In other words, maybe CustomerX wanted to sell exposure on $ 1B of S&P 500, but the trader erred and went out and bought SPY in the marketplace instead of selling it (SPY is a pure hypothetical example here. Don’t get intimidated by any terminology I’m about to use – it may sound complicated at first, but it’s not. If you have questions, leave them in the comments and I will explain it*). Now the trader is long SPY in the market, and long SPY on swap vs CustomerX – he’s doubly long. However, in the system, he books that CustomerX bought SPY on swap (not sold it) – so the trader looks hedged (short to the customer, long in the market). We’ll ignore for a moment the point that any trade this size should have multiple checks and balances to make sure that it’s booked correctly, with senior people at the bank calling the client to confirm the details of the trade.

Now, if the market sells off, the Bank should be looking for margin from CustomerX, who they think is long on swap. CustomerX says “What ‘chu talking ’bout, Willis – I’m short, not long” – and the bank discovers that they have a huge error somewhere, which ends up with the trader taking the fall for trying to conceal his error.

Now, again, this variety of explanation would require 1) a MASSIVE client order booked erroneously and executed erroneously 2) an asset class that moved very swiftly and suddenly – ie, not a move over a period of even a few weeks – more like a few days – so that by the time the margin issue is sorted out and settled, it’s already blown up 3) an actual client trade – not just a trader gone wild. The trader in the example I laid out has a huge error, and is certainly negligent, but probably not what most people think of when they imagine rogue trading. Could something have happened with a massive swap related to the Swiss Franc, booked as we’ve imagined above? I mean, it’s possible, but it would basically have required a huge customer seller of Swiss Francs, which the trader booked as a customer buy, and hedged by buying Swiss Francs in the market. This seems to me to be an unusual trade for a Delta One desk – something that would be handled by the FX desk, but who knows…

Anyway, I started this post by reiterating that I cannot understand how a $ 2B loss can be incurred without multiple people knowing about it, and I still hold that view. There are conceivable ways we can twist hypothetical client trades into $ 2B errors, but they don’t excuse the fact that there has to be negligence at multiple rungs in the chain of command and risk management.

If readers have any ideas of possible asset classes that could have been involved here, do leave your ideas in the comments. My thoughts are: 1) anything in the beginning of August – lots of 10% moves – but that shouldn’t take this long to come to light. 2) Swiss Franc related: possible – that was about 10 days ago. 3) ???

-KD

*glossary: to say that CustomerX “bought SPY on swap” or “went long SPY on swap” means that CustomerX entered into a trade where the customer buys the “return” on SPY from TraderX, but doesn’t actually hold a position in SPY. It’s just the return on SPY that is “swapped.” Now TraderX is “short” SPY exposure to the customer.

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